US inflation-adjusted bond yields are on the verge of turning positive for the first time since March 2020, in a surge that is putting further pressure on riskier corners of financial markets.
So-called 10-year real Treasury yields have risen more than 1 percentage point since early March and hit a peak of minus 0.05 percent on Monday, a sign that bond payouts are nearly beating medium-term inflation expectations.
The rise in real yields was prompted by the Federal Reserve’s attempt to curb strong inflation by aggressively tightening monetary policy. The move already undermines one of the pillars that underpinned a powerful rally in equities and riskier corporate bonds from the depths of the coronavirus crisis two years ago.
“The Federal Reserve will withdraw liquidity,” said David Lefkowitz, head of U.S. equities at UBS’s chief investment office. “It’s the more speculative parts of the market that benefit the most when the Fed adds liquidity, and they [may] face some. . . Headwinds as the Fed goes the other way and pulls back.”
The plunge in real yields of ultra-low-risk US Treasuries deep into negative territory in 2020 sparked a race by investors to seek assets that could offer higher yields, allowing for the effects of inflation. As a result, prices of loss-making start-ups and fast-growing tech giants soared from the March 2020 low into late 2021, with risky corporate bonds also rallying sharply.
This year’s rise in real yields has prompted investors to reassess the value of companies that may not generate large profits for many years. Some private startups like Instacart have agreed to lower their valuations, while shares of loss-making tech companies have fallen more than 30 percent this year, according to Goldman Sachs.
Even America’s S&P 500 index, home of the country’s blue-chip listed companies, has fallen more than 7 percent so far in 2022, with rising real yields combined with uncertainty about the war in Ukraine and surging inflation scared investors. In the corporate bond market, an Ice Data Services index that tracks US junk bond yields fell 6.3 percent over the same period.
This year’s rise in real yields reflects a rise in nominal, or non-inflation-adjusted, borrowing costs spurred by the Fed raising interest rates and rapidly shrinking its $9 trillion balance sheet as policymakers seek to contain mounting pressures on consumer prices steam .
Treasury yields have risen more than inflation expectations, a divergence that suggests investors have confidence in the Fed’s ability to reduce worrying levels of inflation in the years to come. The 10-year break-even rate, a market-based measure of investors’ inflation forecasts for the next 10 years, has remained in a range of around 2.75 to 3 percent over the past few weeks, well below the March 2022 inflation rate of 8.5 percent cents.
“There is a reasonable level of confidence in the Fed’s ability and willingness to fight inflation,” said Ian Lyngen, strategist at BMO Capital Markets. “The issue isn’t whether the Fed’s response is appropriately timed for inflation right now, but market participants’ belief that the Fed will adjust policy if needed.”
The rise in real yields also shows how much the Fed has been able to tighten financial conditions over time, a shift that Lael Brainard, a governor selected to be the next vice chairman, acknowledged last week.
“The announcements of our policy plans have already tightened these broader financial conditions over the last four to five months, much more than you might be able to tell from just the federal funds rate,” she said at an event hosted by The Wall Street Journal.
Borrowing costs for businesses have skyrocketed, as have consumer mortgage rates, which Freddie Mac said last week hit 5 percent for the first time since 2011.
Despite the surge, financial conditions are “still fairly easy,” said John Madziyire, portfolio manager at Vanguard. “It could mean the Fed needs to do more, but it’s too early to know.”
Economists are divided on how much real yields could continue to rise given the rapid pace. But some warn they could bounce again as the Fed tries to curb inflation.
“The $64,000 question is how high real yields go,” Lefkowitz said.